Many of us shy away from buying property because we worry about monitoring the investment. If you have Rs 1 crore or more to invest, private equity (PE) funds that invest in real estate offer an alternative. But analysis suggests that that while these funds reduce risk through diversification and better due diligence, their returns may not beat traditional property investments.
How they work
Real estate private equity funds are close-ended, typically with a time horizon of six to eight years. The funds target three main sources for raising capital — promoters, network of friends/family and high net worth investors (HNI). The minimum investment amount is Rs 1 crore, according to SEBI guidelines. The funds operate on a 2/20 model, with 2 per cent annual management fee and a 20 per cent profit share or “carry”.
The fund may take a few years to deploy capital and the timing of returns depends on the property invested in. For example, rents from commercial property may begin to flow in immediately, but the return of capital from a sale may take long. The term of the fund may also be extended if the projects are delayed or favourable exits are not made.
How they invest
PE funds may offer loans or equity or a mix of both, to developers. PE debt funds usually offer mezzanine funding, loans where the lender has the rights to either asset ownership or equity stake.
A PE fund typically does more homework on its purchases than an individual buyer can manage. A fund that provides equity funding or structured debt (a hybrid of debt and equity) starts by identifying a lucrative theme, which may be based on geography and kind of property. It does detailed market research on sales velocity and pricing in the locality along with forecast of demand and supply. Selecting a builder is also not easy. “We look for builders with a good track record in the particular locality. Metrics include timely project completion, quality, repeat customers and brand image,” says Mridul Upreti, CEO, Jones Lang LaSalle’s Segregated Funds Group. The builder’s track record with other financing institutions and internal systems such as procurement contracts, real-time MIS systems are also reviewed.
Funds also evaluate the technical viability, legal aspects and likely returns for the proposed projects. They negotiate the terms and conditions of the deal with the developers in terms of time-line, profit-share, control and transparency.
Performance
Funds typically project a minimum return or ‘hurdle rate’ of 10-12 per cent and gross annual returns of around 20 per cent. However, there is only very limited performance data available for real estate funds, as most were launched after 2005.
Past funds have managed to deliver a 20-50 per cent gain on capital, according to Shrinivas Rao, CEO-Asia Pacific, Vestian Global. Kotak Realty Fund, among the earliest funds, raised a corpus of Rs 457 crore and thanks to a few profitable exits, has already returned the entire capital to its investors. Its investment of Rs 95 crore in Peepul Tree Properties fetched over Rs 400 crore over four years.
But barring such instances, many early funds have not been very profitable due to entering projects at excessive valuations. For instance, Trinity Capital received only 30 per cent of the investment made in DB Realty after a period of five years. Also, foreign funds have not been as successful as domestic funds, probably because they may be less nimble in finding and acting on localised opportunities.
While most funds had to wait for exits which free up capital, some such as Milestone were still able to offer returns, through regular dividends, thanks to investment in commercial properties with long-term tenant agreements.
Key risks
The primary risk in real estate investments is that the asset is illiquid. This is true for investment through funds as well. Investors typically have to wait for extended periods before redemption.
Another concern is that the property assets are difficult to value and hence an investor does not get accurate and timely information on the performance of the fund.
Also debt-oriented funds may face default risk, as they may be lending to distressed developers at a high rate of interest. Like any other investment, funds are also subject to unforeseen risks such as regulations, localised market changes, interest rates and liquidity.
But risks in real estate PE funds must be assessed just like PE investments in other sectors, says Chinnu Senthilkumar, co-founder and a shareholder at private-equity firm Azure Capital Advisors.
He says that private equity stakes in real estate offer a lower risk compared with investment in technology, for instance, as there is an underlying asset such as land that usually increases in value.
Funds mitigate risks by spreading their capital over many projects. Another way funds are lowering risk is by investing in projects that have shorter developmental cycles. For instance, Segregated Funds Group’s recent fund estimates that investment in city-centric residential projects will likely complete in 2 to 2.5 years, due to fewer approval delays.
Tax aspects
Funds are registered with SEBI as Alternate Investment Funds (AIF) and the tax treatment for the investor depends on the tax pass-through status of the fund. “Category II AIFs are not eligible for the tax pass through status under section 10(23FB) of the Income-tax Act, 1961 read with section 115U”, says Subramaniam Krishnan, Tax Partner, EY.
However, the fund can achieve tax pass-through status with appropriate structuring and the tax can be paid either by the investor or the trust.
If there is tax pass-through, the income (dividends and capital gains) are taxable as if paid directly to the investors. The dividend earned is exempt from tax, after the fund pays Dividend Distribution Tax.
Without pass-through, the investment is treated as buying shares of the fund, according to Rakesh Nangia, Managing Partner, Nangia and Company. Shares need to be held for one year to be treated as long-term capital gains.
While property attracts wealth tax, fund investment is exempt.
Property investors can avail deductions on income and can reinvest gains without any tax incidence. This is not the case for PE fund investments.
Selecting a fund
Investors have a range of choices among the domestic funds. Kotak, HDFC, ICICI, ILFS, Tata, Aditya Birla, Tata, Indiareit, ASK, IIFL, Anand Rathi and Milestone have been in operation. Data from SEBI show that there are ten funds raising capital currently.
The track record of the fund house and returns, weighed against the risk profile, are the key factors to look out for.
Investors also need to review the fund management team and seek information on whether they will stay on till the exits.
Sanjay Dutt, Executive Managing Director, South Asia, for Cushman and Wakefield India, advises that investors look closely at the pre-mature exit clauses and any penalties for early withdrawal, as well as what the fund owes you for extending the lifecycle of the product.
Path Ahead
Although the history of real estate private equity funds is brief, new funds launched recently are able to raise funds.
Without a doubt, the residential segment, especially in cities, is emerging as a favourite among the funds, while the mall and commercial segments are perceived to be more volatile.
Also, most funds are transitioning towards increasing their debt or debt-like exposures.